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When it comes to making money in the markets, investors have two ways: capital gains and investment income. A capital gain occurs when an investment rises to a higher price than an investor paid. In contrast, investment income consists of payments such as dividends and interest, as well as realized capital gains. The way in which these sources of income are taxed also differs.
Here are other important similarities and differences between capital gains and investment income.
What are capital gains?
Capital gains refer to an increase in the value of an asset, such as a stock or a bond. If the investor sells that appreciated asset, it creates a realized capital gain, which is taxable. If the asset remains unsold, the capital gain is not realized and capital gains taxes are deferred.
For example, suppose an investor buys 10 shares in his favorite shipping company for $25 per share. Their total investment in that company is $250. The company has a good year and the stock price rises to $30, meaning the investor now has an investment with a market value of $300.
In this example, the capital gain is $50. If the investor decides to sell the stock, he realizes the capital gain and owes taxes. If they decide to hold on, their capital gains will not be taxed. Investors can hold on to their unrealized capital gains and avoid taxes indefinitely.
Some investors hold appreciated stocks for decades and never owe capital gains taxes. And if you invest with a Roth IRA — one of the best retirement plans out there — you can avoid capital gains entirely, even if you withdraw money from the account in the future.
What is investment income?
While capital gains come from selling an investment at a higher price, investment income comes from a company’s earnings. When a company makes a profit, it can pay out part of its profits as dividends or pay interest on outstanding bonds.
For example, if we go back to our $30 shares, the company may decide to distribute some of its profits to them because it no longer needs to invest them in the company. It then chooses to pay a certain amount of cash for each outstanding share.
Let’s assume the stock pays a quarterly dividend of $0.25 per share. So the annual dividend would be $1.00 per share. So every quarter the investor receives:
The total annual dividend is:
At a price of $30, the share yields a dividend of 3.3 percent.
Realized capital gains are another form of investment income. If an investor sells a stock at a profit and realizes that profit, it legally counts as investment income and becomes taxable.
Important tax considerations
The circumstances for taxing capital gains and other types of investment income vary.
Dividend taxes
Dividends can be taxed in different ways depending on whether they are ordinary dividends or qualified dividends.
- Ordinary dividends are taxed at the ordinary income rate.
- Qualified dividends, on the other hand, receive more favorable treatment at potentially lower tax rates. But you must hold the stock for more than 60 days during the 121-day period beginning 60 days before the stock’s ex-dividend date (for common stock). The ex-dividend date is when the stock price is adjusted lower to factor into the dividend. For preferred stock, the dividend is eligible if you hold it for more than 90 days in the 181-day period beginning 90 days before the ex-dividend date.
Qualified dividends are taxed at rates of zero, 15 and 20 percent, depending on the tax filer’s income.
And other than that not realized capital gains – which do not trigger a tax liability – dividends are taxable for the tax year in which they are received if they are held in a taxable account. Dividends in tax-advantaged accounts, such as an IRA or 401(k), do not create a tax liability in the year they are received.
Capital gains tax
Realized capital gains are also treated in a number of different ways depending on how long the asset has been held and how much income the investor has.
- Selling an investment after holding it for less than a year results in a short-term capital gain, which is taxed at ordinary income rates.
- Selling an investment after holding it for more than a year results in a long-term capital gain, which is taxed at separate long-term capital gains tax rates. Depending on your income, different tax rates apply.
Long-term capital gains tax rates are often lower than ordinary income tax rates. Capital gains are taxed at rates of zero, 15 and 20 percent, depending on the investor’s total taxable income. This is comparable to the highest ordinary tax rate of 37 percent for 2024.
The capital gains tax rates are very affordable. In fact, a married couple filing jointly has a 0 percent capital gains tax rate if their 2024 taxable income does not exceed $89,250. Plus, with skillful maneuvering, you can make more than $100,000 and owe no taxes.
It’s worth noting that investors can also write off losses on their investments and offset their gains against any losses. The process – tax loss harvesting – can save investors significant money when it comes time to pay taxes. And many of the top robo-advisors, including Wealthfront and Betterment, offer free tax-loss savings.
Taxes on interest income
Interest income is generally taxed as ordinary income, meaning it is subject to the same federal tax rate as your income. This applies to interest earned on bonds, savings accounts and certificates of deposit. However, interest on government-issued municipal bonds may be tax-free if they were issued in your home state.
Regardless of whether interest income is taxable or tax-exempt, it must be recorded on your tax return using Form 1099-INT. Interest earned on tax-deferred accounts, such as traditional IRAs or 401(k)s, does not require reporting until you withdraw the funds.
Net income tax on investments
Finally, income from dividends, capital gains and other similar forms of income may face an additional 3.8 percent surcharge, the so-called net investment income tax. The assessment of this surcharge depends on the income and deposit status of the investor.
Tax-free capital gains and dividends
In general, the main way to avoid taxes on your capital gains and dividend income is to own these assets in tax-advantaged accounts such as a 401(k) or an IRA, especially a Roth IRA. Of course, an investor can hold appreciated stocks indefinitely and never pay capital gains taxes.
In short
Capital gains and investment income are two ways investors can make money from their investments, and they are treated differently for tax purposes. So it may make sense for investors to understand which money-making approach works better for their financial needs.
